Why I am Short Deutsche Bank

I typically wouldn’t have much in the way of shorts. At the most they would make up a couple percent. I don’t have a great track record of predicting when companies are going to fall.

I tend to pick them too early. I think its a classic trap of a value investor; you see an overvalued company and you conclude that it has to go down. Unfortunately that is not the way the market works; until there is a catalyst a stock can continue to become more overvalued to the point where you as an investor have no value.

Right now, however, shorts make up a fairly significant percentage of my account. About 15% (though not the practice account I post here because shorting is not supported by RBC). These are extraordinary times.

I have a small short in Argonaut Gold that I mentioned last week. I continue to have a short in Salesforce.com that has done quite well as the cloud computing phenomenon has come back down to earth. I have a short on Tourmaline, an albeit well managed but highly valued natural gas producer in an environment of dismal natural gas prices.

The biggest short I have is in Deutsche Bank. It makes up about 8% of my overall portfolio. I added to it over the last week as DB made yet another failed attempt to stay above $40. Together with a smaller short in UBS, it makes up my “at some point Europe is going to go down the toilet” bet.

Why Deutsche Bank? Simple thesis – it is insanely levered. Here is a snapshot of the European banks common equity to assets. Note the location of Deutsche Bank on the x-axis.

Since that time Dexia blown up.

Jim Grant makes the same point on Deutsche Bank about half way into this interview on CNBC.

Wholesale Funding

The other thing about Deutsche Bank, and to a lessor extent UBS, is that they are not strong depository institutions. What that means is that they do not have a large base of deposits to fund their assets. Particularly in the case of Deutsche Bank they go to the market and borrow money from other banks, from money markets, from pretty much anybody who is willing to lend it, and this is the money they use to fund their lending. When times are good this is a great strategy. Deposits are a more expensive (higher interest rate) form of funding then these wholesale channels (wholesale is kind of the catch-all term that defines all these short term lending sources). But when times are bad, these channels dry up a lot faster then deposits. They can be called quickly in the event of a loss of confidence.

A good proxy for the degree of reliance on wholesale funding is the net stable funding ratio. FT presented the ratio, along with the following graph, in an article a few months back.

One good proxy for this reliance is the net stable funding ratio (NSFR) we have regularly discussed in all our recent sector and company reports. Currently, CASA and SG are among the Euro banks with the lowest NSFR, together with Bankia, UniCredit, Commerzbank + Intesa.

While Deutsche Bank isn’t the worst of the bunch, it is far from the best. Combine that with high leverage and you have a recipe for instability.

All the Devils are at Deutsche Bank

I mentioned last week that I was reading “All the Devils are Here”. Towards the end of the book there is a chapter on the demise of Countrywide. Countrywide, like Deutsche Bank, was not a depository institution. As a result, like Deutsche Bank, Countrywide depended on the wholesale funding markets to fund their assets (in their case mortage loans). It was pointed out by Kenneth Bruce, the Merrill Lynch analyst that followed the company at the time, that “liquidity Is the Achilles Heel” of Countrywide. Said Bruce:

“We cannot understate the importance of liquidity for a specialty finance company like CFC. If enough financial pressure is placed on CFC, or if the market loses confidence in its ability to function properly, then the model can break.”

The difference, at least so far, between what happened to Countrywide and what has happened to Deutsche Bank is that Countrywide went to the Federal Reserve and pleaded with them to use their emergency lending authority. The Fed refused, perhaps because months earlier CFC had switched away from the Fed’s regulatory oversight to the Office of Thrift Supervision (OTS) because they saw greater advantages (read: less strict rules).

Thus far Deutsche Bank has been saved by the unlimited lending arm of the ECB. They certainly would be struggling to fund themselves through their traditional wholesale channels. We know that liquidity has dried up in Europe. We know that the wholesale funding markets (money markets, collateralized repo’s) are getting harder to access and are acceptable less and less forms of collateral (read: German bonds are the new holy grail).

Meanwhile while DB has reduced leverage to the peripheral sovereigns over the last year, they still have fairly significant gross exposure. This gets lost in the shuffle however, because the news tends to focus strictly on the sovereign exposure. For example, this WSJ article points out that:

Deutsche Bank has a relatively low total of €4.4 billion in exposure to the sovereign debt of the troubled euro-zone nations. Its exposure to Italy grew to €2.3 billion at the end of the third quarter from €1 billion at the end of the second quarter…Deutsche Bank has largely hedged its Italian exposure, much of which was inherited as a result of its Postbank acquisition, from €8 billion at the beginning of the year.

True… but gross exposure to the region is significantly higher. You have to look past the sovereign. Below are estimates of DB’s gross exposure to credit in the periphery. DB equity is about E53B for comparison.

Having significant exposure to financials, corporates and retail in Italy, Ireland and Spain is not a good thing right now. Given the austerity measures being imposed how bad do you think the inevitable recession is going to be in these countries? I think its going to be pretty bad.

You might also ask a question about what othe exposure DB has. Given that assets total around E2.2t and periphery exposure is around E100B, clearly there are other things on the balance sheet. Well as it turns out they have a fair bit of exposure to something nebulously called “credit market debt”.

Four years after instruments like “collateralized debt obligations” and “leveraged loans” became dirty words because of the massive losses they inflicted on holders, European banks still own tens of billions of euros of such assets. They also have sizable portfolios of U.S. commercial real-estate loans and subprime mortgages that could remain under pressure until the global economy recovers.

The Journal provided the following comparison of this “credit market debt” exposure for the various European banks:

Again to the Journal, this time speaking specifically about the make-up of Deutsche’s credit market assets:

Legacy assets are also haunting Deutsche Bank AG. The Frankfurt-based bank is holding €2.9 billion in U.S. residential mortgage assets, including subprime loans. It has an additional €20.2 billion tied up in commercial mortgages and whole loans. The bank says it has hedged nearly all of its residential mortgage exposure.

Analysts at Mediobanca estimate that Deutsche’s exposure to such assets amounts to more than 150% of its tangible equity—a key measure of its ability to absorb unexpected losses.

Deutsche Bank said it plans to let most of its legacy assets mature, so it won’t face losses selling them at discounted prices.

And don’t forget the fact that the main business of Deutsche Bank is investment banking. With the seizing up of credit in Europe, that business has to be feeling some pain. Indeed, after reporting 3rd quarter results the CEO Josef Ackerman said:

“During the third quarter, the operating environment was more difficult than at any time since the end of 2008,” adding that the bank’s performance was “inevitably” hit.

Management Matters

One final point. Deutsche Bank announced back in July that their long time CEO (Ackerman) was stepping down and would be replaced by co-CEO’s. now getting back to the book All the Devils are Here, if there was a common trait that pervaded all of the worst of Wall Street in the years leading up to the 2008 crisis, it was turmoil within upper management. Maybe the change over at DB will go swimmingly. But co-CEO’s sounds like a recipe for secrecy and oneupmanship to me. As the WSJ reported:

The bank is resorting to a dual CEO structure for the fourth time in its history, despite the potential for conflict and even a power struggle between the two, because handing the reins to Mr. Jain alone was seen as too much of a culture shock, according to people familiar with the matter...The bank has been working to diversify its earnings mix away from investment banking, which has recently accounted for about 70% of its profit. In the third quarter, investment banking accounted for less than 10% of total profit.

In the end…

Look I don’t have crystal ball that says that Deutsche Bank is inevitably going to fail. I’m sure there are plenty of analysts out there that understand the in’s and out’s of the company’s business better than I have time to do. What I do know is that the evidence points to the conclusion that Deutsche Bank is a bank very dependent on the ECB. The whole bet on Europe is, in my opinion, a bet of whether the ECB eventually steps up to the plate and starts bailing out the sovereigns (and either directly or indirectly the banks) or they don’t. If they don’t, DB, being very dependent on ECB largesse, has to do poorly. Thus, the hedge.

The decline in the stock price to the $2.30 area made me want to re-evaluate my position in the stock. Not so much with the intention of liquidating my position mind you. I was far more interested in whether I should buy more.

I began by stepping through the Gramercy third quarter 10-Q, followed by the recent filings, in particular the 8-K filing made on December 8th that detailed the pro-forma financials ex-realty. Unfortunately, as tends to be the case with Gramercy, the review left me with as many questions as answers.

I have to say that Gramercy has some of the most difficult financial statements that I have ever seen. I spent two years researching Dynegy and even with all their SPE’s and off-balance sheet transactions it was still easier to understand what they were up to then it is with Gramercy. The problem with Gramercy is a combination of

it being difficult to determine what is held at corporate and what is held in the CDO’s and until recently realty

there being overlap between the holdings of corporate and the CDO’s and realty and so some items are netted out even though their liability is non-recourse to corporate

the fact that the CDO’s are basically a black box unless you have access to the managers report and that is not public knowledge (I am still using the only publicly available report which is from March and so therefore somewhat dated)

the company really doesn’t make much of an effort to clarify any of the above.

Anyways, with all that in mind, lets try to draw some conclusions.

Net Asset Value vs. Book Value

One positive of late is that for the first time it is relatively easy to determine the book value of Gramercy corporate. Up until now the mess of CDO and Realty divisions made it a nightmare. With Realty gone, proforma statements were released in mid-December and stated clearly that there are $260M in assets, $40M in liabilities, and $88M in preferred.

Book is $132M or $2.60 per share. Done deal right?

Wrong. Everything is more complicated then it seems with Gramercy.

The first complication is that Gramercy corporate owns a number of reasonably senior securities from their CDO. Because these securities are also liabilities (in the CDO) they are netted out and disappear on the balance sheet.

“In addition, as of September 30, 2011, the Company holds an aggregate of $54.0 million of par value Class A-1, A-2 and B securities previously issued by the Company’s CDOs that are available for re-issuance. The fair value of the repurchased CDO bonds is approximately $40.3 million as of September 30, 2011.”

However the liability in the CDO is, like all else in the CDO, non-recourse, and so the asset on corporate is legitimately accreditive to book. So even though the value of the notes are not on the balance sheet, they should be.

The next thing that is terribly confusing is what is included in the real estate investments. According to the pro-forma those investments total about $80M at cost:

And maybe that’s the end of the story. The problem is that the company said in their last 10-Q (which is for the same period as these pro-forma results) that real estate assets after the transfer of the realty division was complete would total $121.3M with corresponding mortgages held in the CDOs:

“The Company anticipates that all transfers will be completed by December 31, 2011, after which, the Company expects to retain a portfolio of commercial real estate with an aggregate book value of approximately $121.3 million, encumbered by non-recourse mortgage debt held by the Company’s CDOs totaling $94.3 million, which mortgage debt is eliminated on the Company’s consolidated financial statements.”

The (unanswered) question that I have is whether the netting out of the assets and liabilities of these real estate assets includes is included in the above $80M? My guess is that it doesn’t; that because the asset and liability are both on the balance sheet (with the liability being within the CDO) they are netted out just like the CDO notes. But I’m not sure. If I’m right, then the true book should reflect the extra $27M of the commercial real estate portfolio above and beyond the mortgage debt.

But what’s it worth?

The last, and perhaps most ambiguous question about the balance sheet is what the assets are actually worth if they are sold. As noted above, the real estate investments are recorded at cost. I assume the $121.3M is a number also recorded at cost, though that is not clear. But what could this real estate fetch today? Is it substantially less then cost? It wasn’t clear in the pro-forma whether Gramercy chose cost because it was the lessor of cost/fair value, or because they just had to value them at cost.

As for the CDO’s, the notes are recorded at fair value, which means they are being valued at quoted market prices. In reality the CDO debt is either worth all or nothing. Either the CDOs have the cash in run-off to pay back the A-1, the A-2 and the B or they don’t, so its more likely the number is either $54M as they are fairly senior notes and so they are likely to get paid off.

To help make my point with the real estate investments take a look at one of Gramercy’s investments that you do have the information to analyze to some depth.

The joint venture 200 Franklin Square Drive, Somerset, New Jersey is carried at $558,000. Yet income from the property was $29,000 in Q3 and $90,000 for the first 3 quarters. So based on its book value it is returning 20%. I think the book value needs to be higher.

Now this is a case where the book is on the low side. There could just as easily be cases where the asset is booked on the high side. The point is, this whole valuing Gramercy is a ballpark game at best.

What is the deal with CDO-2005?

The deal is that CDO-2005 failed its over-collateralization test again in October after having passed it the previous quarter.

Presumably the main catalyst in the failure was the write down of whole loans to Las Vegas Hilton and Jameson Inns. Together these loans were carried at $42.5M on the CDO books.

The question now is just how far underwater is CDO-2005 and will that CDO be able to cure itself and begin to paying out money to Gramercy again? Well while I don’t have the most up to date data, I can still take a stab at answering that.

As of March 2011 CO-2005 had an outstanding note balance of about $741M. Presumably in curing that balance the first time round (it was cured in July), the note balance was reduced somewhat, to lets say $700M. Based on the current over-collateralization of 115.53%, that would mean current assets in the CDO are around $810M. In order to pass the test with $810M of assets, the outstanding note balance has to be reduced to $686M. In other words the company needs to see a $14M cash infusion to get the CDO passing again and begin seeing cash flow to corporate.

Where is that cash going to come from? From the interest that is diverted to paying down principle for as long as the CDO is not in compliance. As shown below, that interest, which was paid out in the previous quarter as the CDO was in compliance, is a little less than $5.5M per quarter.

The other possibility is that as loans within the CDO are paid off both the numerator and the denominator of the over-collateralization test drop (the assets decline as well as the notes that are paid off with the proceeds). Eventually this would cure the CDO though it would take a lot more run-off, about $90M by my calculation.

The conclusion here is that CDO-2005 is not dead by any means, but that we should not expect to see cash flow from it for another couple of quarters.

Management Incentive

One of the concerns with any of these REIT’s is whether the interests of management are aligned with shareholders. The concern is generally that management wants to keep getting paid and so they won’t necessarily jump at the chance to sell the company, instead preferring to live of the cashflow (and in a worse case the cash) to pay their salaries and bonuses. I think this is the concern of Indaba, who as a large preferred shareholder is attempting to add a board member to get that cash used in share holders interests.

Along those lines though, it looks to me like recent efforts have aligned management fairly well. The have been provided with incentive to sell the company by the end of June 2011. Below is a list of significant shareholders of the company published as part of a 14C on December 19th. Executive Officers as a group own 2.3M common shares in the company, including over 700,000 shares owned by Cozzi.

What I Think

Adding it up, there is no question that there is a lot of question marks here in the numbers. It is difficult to determine the true value of the real estate owned. It is difficult to determine when and if CDO-2005 will cure. It is difficult to know with confidence whether there are loans in CDO-2006 that may fail, causing it to fail its over-collateralization test and thus putting the company in the position where there really is minimal cash flow coming into corporate.

The best I can do is to take the fact that the book is $2.40/share, that $150M of that book is cash, that there is another $50M off balance sheet that is invested in higher end securities in CDO-2005 and CDO -2006 that are almost certain to pay off at par eventually, and that given that the US economy appears to be stabilizing and not falling back into a severe recession, it is reasonable to presume that CDO-2006 will continue to pay out $7M of cash to corporate every quarter for the forseeable future.

Given all of this, I added to my position in Gramercy this week, and I will continue to add as long as the stock trades below the $2.40 level. I was sad to see that we had a bump up in the price on Friday. We will have to see if it sticks. If not I will be ready to buy more.

Gold (and now Silver!) Stock Update

Apart from Gramercy, I made a few small changes to my portfolio this week. I sold out of OceanaGold at $2.45. I had planned on holding the stock until the $2.60 range again but I saw better opportunities but was reluctant to become even more leveraged into gold stocks at this point.

That better opportunity that I saw was Golden Minerals. My broker told me to get in on a private placement of AUM back in the fall of 2010. Nah, I don’t think so I said. I think that placement was at $18. The stock got as high as $24. I bought it this week for $6.25. Pays to wait.

Golden Minerals is another one of these junior explorers (though they do have a small silver mining operation in Mexico now) that has gotten obliterated in the last year. The stock is down 75% off its high. Luckily for the company, that private placement went through with some other poor bastards taking the brunt of it, and so the company is flush with cash. With AUM you are paying $6 and getting a company with a little over $2/share in cash and an indicated and inferred resource of a little over 6Moz ounces of gold equivalent at a 50:1 silver to gold ratio.

The company’s producing mine in Mexico, Velardena, looks promising, but it remains to be seen if they can ramp up production as expected (they want to be producing 4,000oz of gold and 214,000oz of silver by Q4 2012). More interesting to me is the project in Argentina, where they have a fairly high grade (300g/t) silver deposit that sits at 60Moz right now and looks like it has lots of room to grow.

At any rate, its another example of a beaten up junior that was worth a heck of a lot more a year ago then it is now. It seems like a reasonable speculation that it will recover at least some of that value this year if gold and silver prices don’t crater.

Portfolio

This week I finally got my order filled for Gramercy Capital at $2.75. Plan Maestro had another excellent write-up on Gramercy last month. CDO-2005 did relapse and fail its over-collateralization test. This may have something do to with the weakness in the stock. Still, the stock has a net asset value somewhere north of $5. And Bloomberg has had two articles in the past two months commenting on the likely sale of the company to private equity. I feel comfortable holding shares bought at this level and waiting for such a buyout.

While on the subject of US real estate, I began to review some of the regional and community banks this week. Community Bankers Trust, which released Q3 results last week, appears to be on the upswing. The stock remains extremely cheap based on tangible book value or earnings potential. I do not own any regional banks shares at the moment but it may be something worth looking at in the next (inevitable) downdraft.

I added to my position in OceanaGold on Friday. I have had a standing bid in for OGC.to at $2.21, and it was filled. This stock seems range bound between about $2.20 and $2.70. I’m not sure why it cannot break higher. I posted Sunday about the cash generation capabilities of Aurizon Mines. I could have just as easily written about OceanaGold. The only difference between Aurizon and OceanaGold is that Aurizon can continue to generate cash at lower gold prices. In addition, OceanaGold’s costs get misinterpreted to be higher than they actually are because

so much of them are being expensed right now, as opposed to capitalized.

They are in NZD, which has been perhaps the strongest currency in the world this year

Absent these two factors, the first of which is really just smoke and mirrors, and the stock would be trading substantially higher. As it is I am picking up a company with growing production, likely lower costs (the NZD is down from 83 to 78 so far this quarter), and doing it at the lower end of the trading range.

The last trade I made did not show up in the practice account but will next week. On Friday I sold 1/3 of my position in Arcan and planto use the proceeds to buy Midway. I have nothing negative to say about Arcan. They appear on-track. Nevertheless, Midway is a cheaper stock right now, especially after the recent steep drop. Midway also appears to be a good takeover candidate to me, so I don’t mind being diversified in case of such an event.

My portfolio was up rather substantially last week, along with the rest of the stock market. To be honest, I would not have expected it to happen that way.

My portfolio is constructed against what I see as an eventual calamity in Europe, and my expectation that as the dominos begin to fall, perhaps extending as far as Japan, that investors will reconsider the grand 40 year experiment with fiat currency , and with that they will reconsider gold.

(I’m really starting to sound like a gold bug, aren’t I?)

The market, on the other hand, looked at the plan (or plan of a plan depending on how exact you want to be with your language) that the EU laid out on thursday and apparently began to wave the all clear flag.

So what happened? How did gold rally at the same time as the broad markets? Isn’t this a conflicting signal?

Well it is and it isn’t. I think you have to look that the situation through two lenses to truly understand the response of gold, of the stock market and of the bond market.

The first lens is reality. This is what the bond market and the gold market are telling you, and it is all about the inadequacy of the bailout.

The WSJ laid out a fact based piece on the front page of the Saturday Journal. Sometimes the facts are as damning as any commentary. While the market rallied on Thursday, the bond market hardly budged. Sometimes a chart is worth a thousand words.

Worse, on Friday Italy held an auction and was forced to issue 10 year bonds at above 6%.

In Friday’s bond auction, Italy was forced to pay more than 6% interest on its new 10-year debt, approaching levels that some analysts said the country can’t afford for long.

Its actually somewhat surprising that the market has so far shrugged this off. First, it is a pretty scathing critique by bond investors. One day after the grand plan announcement and Italy is paying higher rates than it was even a few months ago.

Moreover, as the above quote alludes to, this crisis began in August when Italian bonds rose from 5% to 6%. The reason that this seemingly innocuous move up was met with such fear by the market is because Italy is basically on the precipice of falling off the cliff of solvency and 1% can throw them over the edge. While Italian government revenues can withstand a 5% interest payment, they cannot withstand 6%.

That is how thin the thread is that Europe hangs to right now. Italy owes $1.9t of debt. When you owe that much debt, over the long run (as that debt comes due) whether you are solvent is more a question of perception than anything else.

Right now the perception isn’t so good.

And let’s look at little closer at some of the details of the plan. First, the EFSF. Do you really think that the EFSF, which according to the same WSJ article is expected to guarantee only the first 10% of Italian and Spanish debt after default (I thought this was supposed to be 20%?) is going to appease investors at future Italian and Spanish bond auctions who have just watched Greece take a 50%+ haircut?

And do you really think that Greece is going to be able to live up to the forecasts laid out in the plan? The recap agreed to will lead to a Greek debt load that will peak at 186% in 2013 and that will fall to 120% by 2020. That alone is worth reading twice. But it gets better. This will take place if you presume their growth scenario of 1 1/4% by 2013 and 2 1/4% by 2015. Seriously.

Given the scenes I’ve seen from Greece the last few days I wouldn’t be betting my pennies that the country will be growing at 1.25% in a little over a year. It looks like a country in collapse mode. As the WSJ points out in another article on Saturday:

Greece is the canary in the euro zone’s coal mine. The bloc’s prescription for a crisis spurred by overborrowing and overspending is a dose of radical fiscal rectitude, delivered fast. To regain the confidence of skittish investors, countries are being asked to rip up paternalistic policies that provided stability and comfort to legions of citizens but left the state reeling from the bill. The question is, can it be done without igniting society into revolt?

Greece has youth unemployment of 43%. They have total unemployment of 16% and rising at a pace that is beginning to look parabolic. And they haven’t even begun to fire the civil servants that they need to in order to meet the austerity measures they have agreed to. The country is being ripped up at the roots and it is supposed to grow again in a year?

Moreover, the one mechanism that could make Greece competitive is off limits. They are stuck with the Euro, which means they are stuck playing on a level currency field with Germany even when they are clearly world’s apart.

On final point. The bailout, and future bailouts, are all going to have to be be paid for by someone. Those someones are Germany and France. Neither of these countries are a fortress of debt virtue. Both have debt to GDP ratios of around 80%. This point seems to get forgotten. The bailout-ers are really not in that much better shape then the bailout-ees.

I could go on. But you get the point. This is not over by a long shot.

But, having given my critique, I did say that I was of two minds right now. What is the other?

Well I was re-reading The Big Short this weekend for perspective. By the summer of 2007, when the two Bear Sterns hedge funds collapsed, pretty much everybody that mattered knew that sub-prime was a big problem. By February 2008, when Bear Stearns collapsed, you would have had to be in a bubble to manage money and still not know anything about subprime mortgages. Yet the market plodded along, rallying at times, until the fall of 2008. And it wasn’t until after the shit hit the fan, after Lehmans went belly up and credit essentially ceased to flow, that the stock market actually began to plummet.

I think that what has to be remembered is that most money managers investing in the stock market are not really being paid to quantify the scenarios in Europe. Its out of scope to have to account for that sort of risk. They probably just want it to go away so that they can return to what they are paid for and go home when they are supposed to.

This deal appears to give them the out, for a while, that lets them do that. What this deal has done is stave off the final denouement for another few months. Enough time that the market can perhaps gleefully rally and pretend again that all is well.

And who am I to argue with that logic? I’m certainly not going to go out and buy bank stocks based on it, but if the market is going to tread water for a while longer, there are a number of stocks out there that could benefit.

With that in mind, I bought some stock this week. The first is I bought back some Equal Energy on the news of their property disposition. As I have already written this is a good deal because it is a deleveraging one. And Equal remains extremely cheap by any metric. There was a very good post on IV that pointed out that Equal’s Mississippian land in Oklahoma is worth $60M to $75M alone at the going rate of recent transactions.

I also opened a new position in Midway Energy. Again pointing to a post on IV, Midway is trading very cheaply based on its current production and cashflow. As teh excerpt below points out, you aren’t even fully paying for the Garrington assets, let alone the potential in the Beaverhill Lake.

With the stock only trading at $3.61/share we believe the stock is not even fully reflecting the value of the Garrington Cardium assets let alone any value for the Swan Hills Beaverhill Lake play. Our base valuation reflecting the 2012 cash flow is $3.00 and the Garrington upside potential adds another $2.50. We therefore believe that investors are getting a free ride on the 40 net sections of Beaverhill Lake rights at Swan Hills with their investment in MEL.

As well I have sold down the extra shares I bought of Jaguar when it got into the low $4 range, and replaced them with shares of Aurizon Mines in the mid $5 range. Jaguar, which was up 35% this week, is an enigma. There was no reason for it to fall as much as it did two weeks ago, and there is no reason it rose last week. I think its pure manipulation. I decided to lighten up before the manipulators changed their stripe.

Finally, one stock that I have not yet bought (back), but that I plan to is Gramercy Capital. The company is cheap, and it probably is going to sell itself sooner or later. I will be buying on any significant correction downward.

Well it wasn’t a great week for my stocks, but there was a bit of interesting news after the bell tonight with regard to Gramercy Capital.

Indaba Capital filed a schedule 13-D. 13-D is a form stating beneficial ownership. It needs to be filed by any owner of shares with more than a 5% ownership. At times it is used as a way of publicizing letters to management. That was Indaba’s intent today.

Indaba published as an exhibit in the 13-D a letter with two objectives. First, it asked management to pay the accrued unpaid dividend to preferred shareholders and second, it made the first steps toward their nomination of a new board member.

I would expect Gramercy to begin to pay the accrued dividends at some point soon, but I can only speculate what managements plans are. As to the board member, I don’t really see this as terribly important to the stock price. So the essence of the letter was perhaps interesting, but did not seem to me to be terribly material to the near term future.

What was interesting were the exhibits provided in the appendix.

Indaba provided the details to a similar unit by unit valuation as what was done by Plan Maestro a few months back. They came back with very similar results.

So according to Indaba Gramercy is somewhere between 30% and 130% undervalued in comparison to its net asset value. Not bad.

I lightened up on Gramercy this week along with a lot of other stocks. But I have to say that I find the stock quite enticing still, its cheap, its value is more disassociated than most to the main driver of the market (Europe). With gold wobbling and my thesis that gold stocks would continue to do well even as the world does not wobbles with it, I think its worth me thinking about whether I should be reallocating capital back into Gramercy and away from some of these gold holdings.

What the news of the settlment does is it allows investors to begin to evaluate the company based on what is left without having to wonder what they might eventually have to subtract. And what is left is a company with a lot of cash, a number of commercial real estate holdings on their balance sheet, a management fee that more than covers Realty expenses, and the equity level stakes in 3 CDO’s filled with primarily commercial real estate securities, 2 of which are paying back significant sums of cash.

Let’s Go Back to the Beginning

I came across Gramercy by way of a few degrees of separation. I actually happened on the analysis from another site, Above Average Odds(AAO). I had originally discovered AAO when I was scouring the net researching Equal Energy. Above Average Odds agreed with me that Equal Energy was undervalued, and just as importantly they recognized the value in the up-and-coming Mississippian play that the market was (and is continuing) to ignore. Their work, in particular their early understanding of the potential of the Mississippian, impressed me enough to continue to follow the site.

Well as it turns out Equal has been the poorest of my oil and gas stocks (I should really know better than to invest in debt laden juniors), though the value is still there. But that’s another story… the point here is that the Equal Energy story led me to a future post from AAO on Gramercy Capital. This post was not written by AAO but my another blogger, PlanMaestro, who writes his own blog called Variant Perceptions. When I initially bought Gramercy, I did so on the basis of the analysis written up by PlanMaestro.

At the time I did some leg work of my own to wrap my head around the story. I read through the 10-K (which was actually the 2009 10-K) and sifted through posts on yahoo and investors hub. It was clear to me that the stock was cheap, that the risks were not as high as perceived, and that was enough for me to buy a piece in the company.

But I didn’t really delve as deeply as I do with most of my investments. I think the reason was that the inner workings of a CDO seemed quite opaque to me, and so I found it kind of intimidating to jump into that pool. This weekend I decided to get a better grasp of the CDO and in particular Gramercy’s CDO’s. On Friday night I printed out the information that was available (a set of the March 2011 managers reports for CDO-2005 and CDO-2006 that someone was so kind to post on googledocs), waited until everyone had fallen asleep, and sat down with a drink and an open ended time frame that I wasn’t going to bed until I understood how these things worked.

It actually didn’t take too long.

In retrospect, I regret not having done a more thorough analysis sooner. It prevented me from recognizing just how much potential this stock has. And while I own a good chunk of the stock right now, I would have undoubtably bought more if I had spent the time to actually understand the CDO’s sooner.

So what did I learn?

The first thing I learned is that CDO’s are not as complicated as their reputation makes them out to be. And Gramercy’s CDO’s are even less complicated then most. As with most seemingly inaccessible subjects, the opaqueness of a CDO revolves around the inaccessibility of the language (mostly acronyms) used. To put it simply, there are a bunch of indsutry lingo used and who the heck knows what they mean. But once you know those definitions you realize the concepts are actually quite straightforward.

Before I talk about the Gramercy CDO’s in particular, I’m going to point to a few basic primers on what a CDO is and how it works.

Ok, so lets look at Gramercy’s CDO’s. I’m going to focus here in this post on CDO-2006. CDO-2005 and CDO-2006 are, the sense of structure, the same. If you understand how the one works you understand the other. Same structure, with each one comprised of different loans and securities. Now there are a few impotant differences between the two in terms of performance, but I will discuss that more at the end.

Onto GKK CDO-2006!

So when Gramercy created CDO-2006, they got together $1B of investment capital, put it into what is called a special purpose vehicle (which is just a fancy name for what effectively amounts to a holding company), and bought $1B worth of commercial mortgage securities.

The $1B of investment capital was obtained by the selling of notes that were divided up into classes (or tranches) based on the seniority of who would be paid back first. The tranches created and the amount of notes in each tranche were:

The highest tranche (1A A-1) gets paid back first. But the highest tranche also receives the lowest return.

And here we get to the first interesting point about CDO-2006. The interest paid to the notes. To put it plainly, the interest being paid to these notes is a steal. Below I have snipped the interest being paid on each tranche of notes for the March quarter.

All of these notes are tied to 3 month LIBOR. If you look at the largest (and highest rated) tranches, their spread to LIBOR is small. Thus, with LIBOR rates non-existent right now, the interest paid for the capital is equally small. I’m sure that in 2006 when the world was rocking these notes seemed like a reasonable investment, but right now they seem like very low returns for the risk of investing in US commercial real estate.

Which is all the better for Gramercy.

What about going forward? Well, who am I to predict the future, but one thing that does make it easier to predict is when you are told what it is going to be. The Fed said they are keeping rates look for 2 years. There’s little to think that the economy could accelerate so quickly as to put the Fed’s word in doubt. I think its safe to say that’s Gramercy’s extremely low cost debt funding train is going to continue.

Below is what 3 month LIBOR has done over the last year.

Looking at the first quarter report, the CDO paid out $1.5M in interest to the tranches not held by Gramercy. That means that they are paying an annualized $6M interest in return for the access to $900M of capital.

When you think about what’s really going on here you have to admit its a little crazy. Compare what Gramercy is getting capital for to your typical high yield industrial company (think Tembec and their issue of longer term debt at 9+%). Gramercy is getting a tremendous deal here. And its all non-recourse.

In CDO-2006 Gramercy owns the J and K notes, as well as the preferred. These would be considered to be the equity level tranches. The J and K notes pay higher interest than the senior tranches at about 3.5% and 7%, but it is the preferred that is the real money maker. The preferred keeps all the excess interest beyond what needs to be paid to the more senior notes. When you are investing $1B in real estate and pay out less than 1% for that capital, there tends to be a lot of excess interest.

Below are the interest payments to the J, K and preferred for the March quarter:

The CDO paid out $7.6M in the quarter to Gramercy in the first quarter. About $30M annually.

One thing that is worth pointing out is that the CDO delivered these returns while holding $158M of its assets in cash. For the sake of interest, lets just do a back of the napkin calculation of how much more interest the company could generate if they put that cash to work at similar interest rates to the assets they already have.

Total interest distribution was $9.1M on total performing CDO assets of $881M. So interest was an annualized 4.1% of assets. The $158M of cash at 4.1% would generate another $6.5M per quarter. All this would go straight to the preferred. So potentially, the 2006 CDO has the opportunity to almost double its return to Gramercy.

Moreoever, my understanding is that a lot of CRE loans are closer to the 6% range. So a 4.1% assumption is likely quite conservative.

At any rate there is the potential to make a lot of money from CDO 2006.

There is however, a limited amount of time forthe cash to be invested. Both CDO-2005 and CDO-2006 are structured such that there is a window in which new cash (from principle payments) can be put towards new investments. After this period ends, once a loan is paid back the proceeds need to be used to pay back the note holders, starting with the most senior first. For CDO-2005 that time has passed. For CDO-2006 that has passed as well, but it passed in July of this year. So we don’t know yet what investments Gramercy has made with the cash. Hopefully its something that pays good interest.

The other stipulation on both CDO-2005 and CDO-2006 is that they both must pass a number of tests before money can be passed on to the equity tranches. The CDO has to pass what is called an overcollateralization test and an interest coverage test.

Both of these tests are straightforward and are exactly what their names suggest. In the case of the overcollateralization test all of the assets currently held by the CDO are added up, any delinquent assets are given a recovery value, and that number of total assets is divided by the amount of notes that has to be repaid. This is done for the various tranches, so for the lower tranches the upper tranches are included in the amount because they will be paid first. Thus, the overcollateralization test for the lowest tranches (F/G/H) is the hardest to pass.

CDO-2006 passed the overcollateralization test in the March quarter.

The defaults are an interesting story in themselves. You can see from the above tables that the defaults are being valued at a little over 25% of their whole value. Its interesting to see why this is the case. Here is a list of the defaulted loans/securities from the same managers report:

Ok, so first of all, the 3 CDO notes from Gramercy 2007 can be ignored. CDO-2007 is a lost cause, and so the fact that these 3 notes are being valued at about 10% is probably right.

Taking a Bit Closer Look at the Defaults

To get a sense of what these defaulted securities might be, let’s look instead at the largest default. Fiesta da Vida. A bit of searching turns up a court document from a couple of weeks ago that describes the current state of the loan:

The documentis the ruling of an appeals court to the original decision that Lakemont Homes Nevada owes Gramercy for the loan they were made by them.

The story is:

Fiesta da Vida, LLC, owned real property located in Riverside County which was to be developed by FDV Investment LLC. In order to obtain financing for the project, title to the property was transferred to FDV Investment LLC (the borrower). The borrower was an entity managed by Lakemont Homes, Inc., a California corporation. On March 30, 2007, Gramercy lent $35 million to the borrower, and the loan was secured by a deed of trust. The loan agreement provided that it would be governed by the laws of the State of New York.

But then real estate in California collapsed and Lakemont Home didn’t repay the loan. So Gramercy went to court.

On February 3, 2010, Gramercy made a motion for summary adjudication of issues as to the second cause of action against two of the Lakemont defendants.4 On May 20, 2010, the court granted the motion. Judgment in favor of Gramercy was entitled in the amount of $33,537,994.65, plus costs. On July 22, 2010, Lakemont appealed.

The interesting ending to this saga is that the apellate court ruling on the appeal affirmed the judgement in favor of Gramercy.

So what does this all mean? I don’t know enough to say. While the court affirms that Gramercy should get their money back, for that to happen the money has to be there. I did some searching for Lakemont Homes and FDV Investment LLC, who seem to be the borrowers here, and I can’t find more than a name referencing the company.

And when I look at Riverside real estate prices, it doesn’t give me the warm fuzzies about the area (these are residential prices mind you):

On the other hand, one would think that for Gramercy to spend the time in court there must be some carrot they are chasing. We shall see.

Anyways, I digress…

What is CDO-2006 Made of?

The last thing that I want to talk about is what the CDO-2006 is actually comprised of. Luckily, this information is all available in the managers report (note: I originally had posted a breakdown in loan data that I was told was better left un-posted. What remains is the general aspects of the loans, which is still sufficient for drawing the conclusions I looked to draw).

The CDO contains 54 different investments as of the end of March. Most of these are whole loans, while the rest are collateralized mortgage products. You can see the breakdown in the table below:

A few points that I made note of as a perused the contents of CDO-2006:

Many of the loans are simple first lien loans against a property.

There are 3 Gramercy CDO-2007 notes in CDO-2006. These were bought in 2009. They are lower tranches (would either be mezzanine or equity) and so I think they are dead in the water. I wonder why they bought these?

The three biggest whole loans on their books $48M, $45M, $42M. So they are not overly leveraged to any particular CRE property.

One point that is worth spending some time on is just what type of CMBS and CDO’s are owned by CDO-2006. The first thing I note is that of the CMBS and CDO’s owned, all except for the NSTAR 2006 carry interest rates of above 5%. This is good as long as they are performing (which most of them are). But it also implies that these are very low tranches and may not see full recovery. So lets look for a second at what the ratings are on these notes. I made the following table from a larger table provided in the report. I reduced it to only include CMBS and CDO’s.

Moody’s ratings system is as follows (taken from Wikipedia):

It looks like $92M of the securities are not investment grade (includes 2 securities not rated by Moody’s but by S&P).

What does this mean for Gramercy? The tranches of notes that Gramercy owns are the lowest, and they make up the final $96M of the total notes sold. So to eventually recover principle on the CDO, Gramercy needs some of these non-investment grade securities to pay up.

That’s not an impossible task, particularly considering that many of the non-investment grade securities are at ratings on the cusp of investment grade (Ba1, Ba2 and Ba3).

One final piece of information about the properties owned that is relevant is where these properties are. You can go through the list individually to determine this information, but some general location information can also be gleaned by a few of the CDO requirements tests. CDO-2006 has some requirements about how much real estate can be owned in any particular state. As part of the managers report there are a number of tests to see whether these requirements are met. These tests, and the amounts owned in the central loan states, are in the table below:

So What did I Learn?

This started off as a mostly educational exercise for me. I wanted to understand how a CDO worked and CDO-2006 was my lab rat. And I think I achieved my goal. I now have a much better understanding as to what a CDO is comprised of, what its liabilities are, how its interest is paid, and what how its solvency and liquidity tests are calculated.

As it more specifically applies to Gramercy, I learned the following:

The interest that the CDO is paying on much of the $1B in capital makes this extremely cheap money

The equity tranche of CDO 2006 is much more leveraged to performance than I anticipated.

The cash level that CDO-2006 had in March is perhaps the most important element of the CDO. That cash could be converted into significant extra dividends to the Gramercy owned preferred once that cash is put to work

The eventual recovery of principle in CDO-2006 depends on the recovery of a number of CMBS and CDO securities that are not currently investment grade and so full recovery is no sure thing.

What’s Next?

the next thing I want to write-up is CDO-2005. As I said at the start, the structure of CDO-2005 is similar to CDO-2006. However, there are key differences in their current state. CDO-2005 was, for quite some time, failing its overcollateralization tests. But it was just barely failing, and there was a news release at the beginning of August that it had begun to pass again. Now I need to spend some more time crunching the numbers on CDO-2005, but as a first pass it looks to me like the CDO should return between $5M to $6M quarterly to the holder of the preferred shares once the over-collateralization test is passed.

See the thing is, when the CDO fails its overcollateralization, all the interest to equity gets diverted to paying off principle of the senior notes until the test begins to pass again. So Gramercy hasn’t gotten anything from CDO-2005 for quite some time. If I’m right about my numbers (and please take them with a grain of salt at this time because i have not gone through CDO-2005 in the detail I did CDO-2006) then that is another $20M to $25M in yearly cashflow to Gramercy. That is 40-50 cents per share, which is nothing to scoff at.

But that is yet another story. This post was about CDO-2006 and learning about how CDO’s work. I think I’ve said enough about that already.

On friday I wrote that after having sold Gramercy Capital a couple of days before, I had decided I couldn’t stay away from the stock and had bought it back (some 20cents higher). Call it gamblers intuition, or call it luck, I just had a feeling that a settlement of their Realty loans was around the corner.

Well that’s not strictly true. There were signs. The stock was rising in a falling market. Volume was up. A call to the company by a poster on Investors Hub returned an answer that they were getting closer to a settlement.

Last night after the market closed Gramercy announced that they had settled their mezzanine loan with Goldman, KBS, and Citigroup.

The terms of the deal look quite reasonable. The company basically hands over their Realty division (less 58 encumbered properties that Gramercy will continue to hold). In return they get a $10M per year management fee with incentive structure that will provide a minimum of $3.5M per year.

Gramercy has about 50M shares outstanding, so the fees they will receive from Realty management going forward are around 25 cents per share. That isn’t small potatoes for a stock trading at $2.80.

More importantly though, the overhang of the unknown is over and investors can begin to value Gramercy on their remaining assets. Going a long way towards that will be that Gramercy is now able to file its 10-K’s and 10-Q’s.

I expect that the financial statements will show a company with net asset value of $5+ per share.

The sale also leaves a company that is ripe for takeover. From Bloomberg:

“What remains of Gramercy may be an attractive acquisition target both for buyers of discounted financial assets and someone looking to acquire a public real estate platform,” Ben Thypin, director of market analysis for New York-based Real Capital, said in a telephone interview. “The company may be an appealing target for private-equity firms with dry powder committed to real estate that they need to deploy.”

I am very glad I bought back on Friday. If it wasn’t for what I perceive as some serious problems in Europe on the horizon, I would probably buy more this morning.

I couldn’t stay out of Gramercy. I bought back in yesterday at the end of the day, at $2.80. I sold more Oneida Financial to keep my overall cash position the same.

I know, my decision making is flailing a little here. I admit, I’m finding it difficult to make decisions here. I see plenty of opportunities out there. Even beyond the stocks I own. There are oil companies, for example, trading at a third of what they were a few months ago.

Take Emerge Oil and Gas (EME.to). Does it deserve to have been cut down by 60% in a few months? Oil prices are still at $80/bbl after all. The company’s production has declined slightly but nothing too severe. Still, a 60% decline in share price?

There are lots of stories like that out there. Lots of stocks that I would jump on in normal times. But as I wrote about last week, I don’t think these are normal times.

The latest evidence I’ve read describing the lack of solidarity in the Eurozone came from this FT article. Don Coxe said on his call this week that the default of any European sovereign would be “a nightmare”, except that the analogy was flawed because you do eventually wake up from a nightmare.

Scary stuff.

So I bought back Gramercy. I saw the volume over the last few days and I have heard the company say themselves that they are getting closer to a settlement of realty, and so I was loathe not to be long the stock coming into a Monday morning where news might be sprung.